The Fallacy of diversification

If you want to explode your portfolio returns a way of doing this is by learning how to ride stocks that are on the big momentum waves but doing it in a very unemotional and controlled environment. This will help you maximise the trend potential.

A simple and naturally occurring analogy is that of an ocean wave that breaks and subsides. You jump on (enter) the wave when it breaks, ride it as long and hard as you can, and get off (exit) before it subsides. That’s fun and very satisfying.

Explosive trends have mesmerised and taunted investors for years as stocks propel themselves ever higher. Getting on them and off them at the right time is the tricky bit. The perceived safety of diversification to try and capture these stocks is a fall-back strategy that only ever really generates average returns primarily because the losers drag the strategy back to average. Don’t lose heart, let’s now focus on the big winners.

Research completed on ‘wave’ trading over a 16-year period has exposed an interesting if not confronting outcome. Using a methodology of ‘conviction’ portfolios‘ that focus on a smaller set of stocks has provided superior results.

How do you find them, how do you run with them, and when do you get out of them before they turn nasty, so you keep those hard-earned profits? For this conundrum I offer a solution.

There are periods when stocks bloom and in characteristic fashion they surprise us all. Stocks propelled by perceptions of what might happen in the future nearly always exceed our expectations because humans can and will believe almost anything.

This period of euphoria rarely lasts however, and like a wave that breaks, it runs, but then it (always) subsides. The same effect repeats itself.

That period of excessive price euphoria, or momentum, is our target. To use our emotionally driven minds is rarely the best way to capture these stocks and in reality, a robot could do better given some basic trading rules. So, let’s test that theory.

Real examples: ALU more than doubled its price in 2017/18, A2M nearly quadrupled its price in the 15 months to April 2018. And more recently FMG increased 59% from Jan 2019 to March 2019. Annualised out that’s about a 240% return. These are big rallies which have all been robotically controlled with ‘break out and catch the wave’ entry techniques and money management exits.

There are examples across the market of this type of stock behaviour as stocks blow the valuations out of the water and capture our minds. I don’t profess that we can get all of them and we don’t need to – just some. This process is also not without periods of adjustment as no system is perfect but over time the accumulated profits have more than compensated for this. See Graph B below

The strategy used for this type of stock selection is driven by systematic process driven analysis to enter a position, while the exiting of position is executed and controlled purely by a risk management process. It is robotic of nature. i.e., if this happens, I do that, and if that happens, I do this. This is a systematic methodology that helps us more efficiently capture the major portion of excessive price moves.

That’s a good thing because emotional trading that occurs during market surges often doesn’t exit the market as a good risk management process must. The ‘hang on it’ll get better’ disease has no cure. You have to change your ways!

This process plays a numbers game of selection which quickly discards the weak and runs with the strong. Based on basic rules of investing that follows a process, and then testing various portfolio sizes i.e. number of stocks held, based on trading signals over a period of 16 years, it reveals that smaller conviction portfolios do this best because we place bigger bets on the winners. As our bias is always to winners this approach magnifies that effect.

I have tested various portfolio sizes over various market capitalisation groups from the top 200 ASX stocks with a selected 100 stock group yielding the optimum results. The results vary but the best come from the smaller conviction portfolios of just 5 stocks. See graph below based on a top 100 selected group and a smaller midcap 50 group.

Graph A:

Or to look at the top performing 5 stock portfolio based on the Top 100 universe another way:

Graph B: benefits from the compounding effect

So rather than trimming the edges of mistakes as a diversified portfolio does it seems it also trims the edges of the winners by spreading the risk too far. What we want to do is leverage the winners by placing bigger bets on them and riding them hard, but at the same time not losing the objective of still keeping capital safe.

What are your thoughts on how best to manage and run a portfolio of stocks?

A comprehensive research document is available on the Stockradar home page under the About menu. Stockradar Premium Portfolio Strategy

The majority of stocks underperform the index – fact. They provide average returns and by holding them put a drag on portfolio results and this is primarily what index managers do. As stocks go higher, be it miners or banks, their large market capitalisation dominates index moves and masks the lower capitalised big performers. It also means index fund managers need to hold more of these big stocks in your fund, and when they eventually go down, which they always do, you go with it. This aspect of index fund management needs to be properly addressed because it causes unnecessary capital decimation and means they follow indices down and miss the big moves by being underweight lower capitalised top performing stocks. Why the obsession with the index?

The attraction and challenge of the stock market is the lure of the dollar and the stocks that offer these riches. Some investors have found a way to capture and ride these profitable waves. Stockradar’s methodology of selection and stock management quickly discards the weak and runs with the powerful.